How Do Student Loans Work? Demystifying Student Loans, Types, Interest Rates and Repayment Options

Many college students rely on student loans to pay for their education. Whether you’re heading off to college for the first time or pursuing an advanced degree, it’s likely you’ll need to take out loans. But with so many loan servicers and types of loans, where do you start? We can help with that.

Before you apply, you should learn about all the different types of available student loans and their terms. This will ensure you choose the right loan options for your financial situation—now and after you graduate. Let’s break down the major types of student loans you might pursue, so you can make the most informed choice for your education.  

What Are Federal Student Loans?

Federal student loans are issued by the government—specifically, the U.S. Department of Education. You apply for these loans by filling out the Free Application for Federal Student Aid (FAFSA) form. 

In most cases, federal student loan approval doesn't consider your creditworthiness. This means your application won’t be denied because you have no credit history. Once approved, federal student loans are administered by one of a select group of loan servicers.

There are many benefits to federal student loans. These loans offer fixed interest rates, meaning they remain the same throughout the life of the loan. The interest rates for federal loans are usually more favorable than private loans as well. Federal student loans also come with several deferment and repayment options, offering you flexibility when it comes time to pay your debt.

There are several different forms of federal student loans you may be eligible for:

• Direct Subsidized Loans. These loans are given to undergraduate students who demonstrate financial need. The loans are subsidized while you’re in school, meaning the government pays the interest that your loan accrues. You’ll be responsible for paying the interest on Direct Subsidized Loans starting 6 months after college graduation.
• Direct Unsubsidized Loans. These loans are issued to undergraduate and graduate students without significant financial need, and the interest isn't subsidized. You’ll be responsible for paying the interest that accrues throughout your schooling.
• Direct PLUS Loans. These loans are issued to graduate students and/or the parents of undergraduate students. They’re designed to help cover extra education costs. Unlike the other federal loans, Direct PLUS Loans do require a credit check. Parent PLUS Loans are taken out by parents directly—not students. 

If you apply for student loans, you may be offered a combination of Direct Subsidized and Direct Unsubsidized Loans. However, there is a cap to how much you can borrow. These loan limits will vary depending on whether you’re an undergraduate or graduate student and whether you’re dependent to your parents. Direct PLUS Loans can help you cover the remainder of your educational costs.

What Are Private Student Loans?

Private student loans are educational loans issued by banks, credit unions and other private institutions. In some cases, state agencies or even your school might issue private loans.

Unlike federal student loans, private student loans are subject to credit review. This means you’ll have to apply for the loan, and your lender may approve or deny you based on your income and creditworthiness. If you don’t have good credit history, you may need a co-signer, like a parent. Undergraduate students, graduate students and parents can all apply for private student loans.

Private student loans don’t always come with the same benefits that federal student loans do. Interest rates on these loans might be fixed or variable, and the interest rates may be higher. Private loans are usually unsubsidized, so you’ll be responsible for all the interest that accrues. Repayment options might also differ, depending on your lender and terms.

That doesn’t mean private loans are all bad, though. Unlike with federal student loans, there’s no cap to the size of your private student loan. If you have enough income or good credit, you can potentially borrow as much as you need to cover all your educational costs. Private student loans also make great gap-fillers if federal loans don’t cover all your expenses. If you use a co-signer with excellent credit, you may be able to secure a loan with more favorable terms.

How Student Loan Interest Rates Work

One of the most important things to understand when taking out student loans is their interest rates. The amount of interest your loan accumulates will be calculated based on the Annual Percentage Rate (APR) and your loan balance. Interest will accrue during and/or after college, depending on your loan type. This interest will continue to build even if your loan isn’t in active repayment. Once you begin paying, you’ll need to pay the interest on top of your principal loan balance. 

Student loan interest is calculated daily based on your interest rate. Many student loans use “simple interest,” meaning the interest is generated from your principal loan amount only. Your monthly payment will typically cover the interest accumulated that month. 

However, some loans use “compounding interest” (also known as capitalization). This means that any unpaid interest gets added to your principal loan amount. Then, interest generates from the new total. Over time, capitalization can make your loan balance grow much higher than what you originally borrowed.

Certain loans compound interest at specific times, like at the end of your grace period. Unless you pay it off, the interest that accrued while you were in school is added to your loan balance. It helps to have a strategy to pay off interest before it capitalizes to save money in the long term.

Whether simple or compounding, the interest rate on your loan matters a great deal. It will impact your monthly payment and the total amount you pay back for your loan.

Federal student loan interest rates

Interest rates for federal student loans are typically lower than those for private student loans. The government determines the interest rates for federal student loans each year. Everyone who qualifies for federal student loans receives the same rate that year. These rates are fixed for the life of your loan. 

There are different interest rates for each type of federal loan:

• Direct Subsidized and Unsubsidized Loans have the same interest rate for undergraduate students.
• Direct Unsubsidized Loans have higher interest rates for graduate students.
• Direct PLUS Loans have higher interest rates for graduate students and parents. 

The U.S. Department of Education announces the next year’s federal student loan interest rates in the spring. Each year you take out student loans, you may have a different interest rate than the year before. This means you may have several loans with different interest rates from each subsequent year of school. 

Private student loan interest rates

The interest rates for private student loans can vary significantly from lender to lender. Typically, your interest rate will be determined by your credit score, income, loan amount and loan terms. A longer loan term may come with a higher interest rate, and a shorter loan term may have a lower interest rate. 

Private student loans generally have higher interest rates than federal loans. However, it’s possible to secure a more favorable rate on a private student loan if you have excellent credit. Having a co-signer can also help reduce your interest rate.

Additionally, private student loan interest rates may be fixed or variable. Fixed rates stay the same over the life of the loan. Variable rates may change throughout the year, depending on market changes. 

Repayment Options for Student Loans

The other things to understand when you take out student loans are your options for repayment. Federal and private student loans may have very different repayment options. It pays to do your research ahead of time, so you can make a plan and budget for student loan repayment. 

All federal loans and some private loans will allow you to make minimal or no payments until after you graduate. However, paying even a small amount throughout college can help keep interest under control.

Members of the armed forces may benefit from additional repayment options. Check with your military branch to see if they’ll help pay off your student loan debt or if you’re eligible for benefits like interest rate caps or deferment. 

Federal student loan repayment options

Federal student loans have the most flexible repayment opportunities. Repayment also doesn’t start right away. While you’re in school at least half-time, your federal student loans are placed in forbearance. This is followed by a 6-month grace period after you leave school or graduate. 

During forbearance and the grace period, you aren’t required to make any payments. However, interest will still accrue on applicable loans (like the Direct Unsubsidized Loan). The exception to this rule is Parent PLUS Loans. These loans typically begin repayment immediately.

After your grace period ends, you’ll be expected to make monthly payments. There are 4 main types of federal repayment plans you should know about:

• Standard repayment. Under standard repayment, you’ll make fixed, equal payments every month for 10 years. This is the best plan to use if you want to minimize the interest your loan accrues.
• Graduated repayment. Graduated repayment starts with lower payment amounts that increase every 2 years. You’ll pay off your loan in full within 10 years. This payment plan is ideal if you expect to earn more money over time. 
• Extended repayment. Student borrowers with large loan balances (over $30,000) may be eligible for extended repayment. This allows you to make fixed or graduated payments over a term of 25 years. You’ll pay more interest on an extended repayment plan because your loan term is longer.
• Income-driven repayment. There are several income-driven repayment (IDR) plans available to low-income borrowers. These plans typically cap your payment as a percentage of your annual income. You may be eligible for loan forgiveness after 20-25 years of consecutive payments. 

You’re typically allowed to change the repayment plan you use for federal student loans. This gives you added flexibility if your financial situation changes, like if you lose your job.

Private student loan repayment options

Private student loans typically have much stricter repayment options. The exact terms of your loan will depend on your lender.

Some private student loans have a similar forbearance and grace period to federal loans while you’re in school. Other loans may cap your monthly payments or expect you to only pay interest until you graduate. Others still may expect you to make full monthly payments during college.

The majority of the time, your private student loan payment will be fixed every month. You might have a long or short repayment period, ranging 5-25 years. If you’re struggling to make your monthly payments, you may have additional options available through your lender. 

Choose the Right Student Loan for You

If you plan to take out student loans to pay for your education, research is key. Make sure you understand the different types of loans available to you and how their interest rates and repayment will impact your finances. Armed with this information, you can craft a repayment strategy and set yourself up for success after graduation. 

You may end up needing both federal and private student loans—and that’s okay! In general, it’s recommended to max out your federal student loan options before turning to private loans. 

If you still have college expenses, Navy Federal’s private student loans can help fill in the gaps. We offer several repayment options and favorable interest rates for creditworthy borrowers. Let us help you pursue your dream of education!